Why China doesn't have a big bond problem

Concerns may be rising over potential defaults in China's bond market, but the risks may be exaggerated, Deutsche Bank said after combing through the country's bond issuers.

"Investors seem to have misunderstood the critical difference between debt markets in China and other countries, and as such have overestimated the probability of default," the bank said in a note dated Monday. "The critical difference lies in the ownership structure of companies issuing these bonds, making the loss induced default ratio much lower than investor perception," it said.

After conducting a proprietary study of the 2,400 Chinese corporate bond issuers, which have issued around 5,500 bonds, Deutsche Bank believes the eventual default rate may be lower than the global average of 1.08 percent.

The study comes as another Chinese company appears headed for a bond default. Local media reported this week that Zhejiang Huatesi Polymer Technical applied for bankruptcy in early March. The small polyester yarn maker sold 60 million yuan (around $9.7 million) in bonds at 11 percent in January of last year, with the next interest payment due in July and the bonds' maturity set for next January.

Deutsche Bank's study found around 308.4 billion yuan (around $49.82 billion) of bonds from 88 issuers could face suspension from trading due to posting losses for 2012 and the first half of 2013, but 74 of those are state-owned enterprises (SOEs), which are unlikely to default. Trading in a company's listed bonds is halted after it posts two consecutive years of losses.

"A default by any of these SOEs can loosely be seen as a potential default by the state, a scenario which China is highly unlikely to allow, and hence step in to help their troubled subsidiaries in case of repayment difficulties," it said.

Only 14 of the money-losing issuers are privately owned enterprises (POEs) and their total issuance is small at 18.8 billion yuan, it noted. China has around 7.4 trillion yuan (around $1.20 trillion) in outstanding bonds, it estimated.

"Given the minor issuance size, we do not think it will be a big burden on the economy or the banks even if all these bonds are defaulted," it said.

The impact on banks is also likely to be limited by around 65 percent of the 88 money-losing issuers being involved in overcapacity sectors, such as steel, mining, metals and solar energy, where banks have been cutting back their loan exposure, it noted.

It estimates China's listed banks' lending to overcapacity sectors only accounts for 3.3 percent of their total loans, with any asset quality risks likely limited as most of the loans were to market-leading SOEs.

While China's commercial banks hold around 38 percent of all the outstanding corporate bonds, it accounts for only 2.4 percent of their assets, it noted.

Deutsche Bank expects anxiety over China's bond market will fade soon as May is a bond payment peak for POE issuers considered higher risk either because they are money losing or because their credit rating was downgraded, although it noted these are only 0.39 percent of the corporate bond market.

"While nobody likes defaults – investors, issuers or even us – they are a part and parcel of a healthy and competitive market mechanism," the bank said in a note dated Monday. "For that purpose alone, we believe that the rising corporate defaults in China are not necessarily as bad as the investor community thinks them to be."